Guest Posting – The Dividend Aristocrats

We’ll kick off the new year with some more advanced study: here is another angle on Dividend Stock investing from guest author Sean Owen.

Sean is an engineer, lawyer, and writer. His articles on investing and finance have been featured by Forbes, the Huffington Post, and Seeking Alpha, among others. He blogs about financial indepedence and sustainable living at RenewableWealth.com.

The Aristocrats

Now that you’ve had an introduction to the wonderful world of dividend investing, you might ask yourself, what could be better than a company that pays you every quarter for the privilege of having you as a shareholder? How about a company that gives you a raise every year? It turns out that there are a number of companies out there with a proven track record of doing exactly that, and there’s an easy way to find them.

Enter the Aristocrats

No, I don’t mean the aristocrats from the infamous joke you may have heard about. The S&P Dividend Aristocrats is an index that consists of companies that have raised their dividends every year for at least 25 years in a row. This is an elite club indeed, because if a company ever misses a single dividend payment, or ever fails to give investors a raise, then it is booted out, and must start that 25-year clock all over again if it wants to get back in.

The index currently includes many familiar companies, like Johnson and Johnson, McDonald’s, and Wal-Mart, but there are others on the list that aren’t necessarily household names. Companies like Abbott Labs, Dover Corp, and Pitney Bowes may not make many headlines, but they have also paid increasing dividends for 25 years or more.

That period includes several nasty recessions, including the most recent one, which is the worst since the Great Depression. The share prices of these companies may have fluctuated during these rough patches, but they kept raising their dividends relentlessly through it all.

Boring is Best

Many people think of these sorts stocks as “boring.” Traders often deride them as being for “widows and orphans.” Many will tell you that a company that has paid increasing dividends for 25 years is too big to grow. My response to that is, as my dad would say, horse hockey. The Dividend Aristocrats have outperformed the S&P 500 over the previous 5, 10, and 20 year periods — quite handily, in fact.

Here’s another way to look at it: A company that pays steadily rising dividends is a company that makes so much money, year after year, that it simply can’t use it all, and they believe the best use of all that extra cash is to reward their shareholders. That sounds like a company I want to own.

An Example from Warren Buffett

For a great illustration of the amazing power of dividend growth investment in general, and dividend aristocrats in particular, we need look no further than the world’s greatest investor. Warren Buffett established a position in dividend aristocrat Coca Cola in 1994. Check out his comments on that investment from a letter to Berkshire Hathaway shareholders:

Coca-Cola paid us $88 million in 1995, the year after we finished purchasing the stock. Every year since, Coke has increased its dividend. In 2011, we will almost certainly receive $376 million from Coke, up $24 million from last year. Within ten years, I would expect that $376 million to double. By the end of that period, I wouldn’t be surprised to see our share of Coke’s annual earnings exceed 100% of what we paid for the investment. Time is the friend of the wonderful business.

You read that right — by 2021, if Coca Cola stays on its current trajectory, the shares Buffett bought will earn more in dividends alone every year than his entire investment back in 1994. How’s that for boring?

My Shares Have Gone Down? Awesome!

There’s a sort of magic in investing in companies like these. When you stay focused on collecting your paychecks from the companies you own, rather than the share price, you can ignore the wild fluctuations in the stock market that keep less enlightened investors awake at night. You can simply sit back and collect ever-increasing income from your portfolio.

In fact, if you reinvest your dividends (which I highly recommend you do), you might just learn to love it when your favorite companies’ shares go down. How can that be? Because those reinvested dividends will buy you more shares when the price is low, which will in turn earn even more dividends in the years to come.

Investing in the Aristocrats

So what’s the best way to invest in the Dividend Aristocrats? One simple way is this the SPDR S&P Dividend ETF (SDY). This is an exchange traded fund that tracks the S&P High Yield Dividend Aristocrats index. This is a slightly different index which includes Dividend Aristocrats from the S&P 1500, rather than just the S&P 500, but it has the same 25-year dividend growth requirement. It has reasonably low expenses, and currently sports a very respectable 3.3% dividend yield.

If you don’t want to put a whole lot of time in learning how to evaluate individual stocks, you could very well just stop here. The holdings in SDY are quite well diversified, and represent many of the most rock-solid companies across a wide variety of sectors. It’s a portfolio that will let you sleep well at night, whichever way the market is moving.

An Elite Cheat Sheet

If you prefer to pick your own stocks, whether you’re a seasoned pro or just starting out, there are no shortcuts. Doing your homework on each and every stock you consider for investment is absolutely essential to your success. It can be a daunting task when you have thousands of stocks to choose from.

The 2012 High Yield Dividend Aristocrat index only has 61 companies on it, though. If you narrow your search to these, doing your due diligence suddenly feels a lot more doable.
In fact, it’s perfectly feasible to do a thorough analysis on each and every company on the list, and that’s precisely what I recommend you do before investing a dime, especially if you are new to investing.

For a great primer on valuing stocks, check out the Intelligent Investor, by Warren Buffett’s mentor, Benjamin Graham. Read it, and then get to work combing the Aristocrats for bargains. It will be time well spent. You will be a much better investor when it’s done, and you will have an opportunity to practice the #1 most important skill for any investor to have: patience.

You might want to read the previous dividend guest article from Dividend Mantra (and the lively discussion that follows!). In that article, you will see a link to a follow-up that J.L. Collins wrote on his blog. Dividends aren’t magical – they are just payment that makes explicit the value you are getting when you own the stock of a profitable company. If the company retained the dividends, their stock price would theoretically go up by an equal amount (on average over time), then you could sell individual shares and end up with the same income with the same amount left over. Don’t buy any stock until you understand the difference between these two types of companies.

I’m publishing these articles not to advocate individual stock picking over indexing, but rather to help explain conceptually what stocks ARE in the first place. Most people think they are a complicated gambling instrument, rather than an actual legal ownership slice of a real business where YOU are entitled to a share of its profits for as long as you hold that share.

In short, stock investing is Great! Dividends just make it more obvious to non-financial types.

Nice article JL – The plentiful cartoons make it much more fun to read. I’m a little sad that you painted this blog as a bandwagon jumper regarding dividends (I didn’t even know there was a growing trend, I’m just trying to explain what dividends are!). But oh well.

I totally agree with your nice crusty old man sentiment about bubbles – I also enjoy regularly mocking the run-up in gold prices (and I hadn’t even realized it went to $1900 at one point this year, holy crap!).

Finally, regarding a potential dividend stock bubble: the way we will know if a bubble is forming is if the share prices rise faster than the market, driving up P/E ratios relative to other stocks, and driving down dividend yields. This may have already happened during the last few years, I just haven’t taken the time to research it (anyone?).

But I am horrified to hear I’ve come across as painting your blog as a bandwagon jumper of any kind. Not so and my sincere apologies.

Far from it. I wouldn’t be posting here if I didn;t value and very much respect what you are doing here. All investment approaches are worth discussing and I applaud you’re inviting the guest posters you have.

Both have been excellent writers and each has clearly presented their styles.

One really nice thing about dividends is it makes it much harder to cook the books when you also have to cough up the loot. Either you have a fat wad of cash to disperse or you don’t. Something even financial types who are astounded by the current pervasiveness of fraud can appreciate.

Blue, adding to MMM’s response – why not to invest in dividend stocks? Perhaps you don’t have any “room” left in your tax-deferred / tax-preferred accounts, and are only left with money in regular taxable accounts. If that is the case, you probably shouldn’t buy dividend stocks, as their annual dividend payouts are taxed each year, which is a parasitic loss to wealth building (since you want any gains or income to be deferred for as long as possible).

If you want value companies that have large earnings and good free cash flow (i.e. that resemble most other dividend payers, except they distribute their earnings to you through share buybacks rather than dividends), you can these kind of “silent dividend” payers, and buy those for your

I wrote “you can these kind of “silent dividend” payers, and buy those for your” – I meant “you can find these kind of “silent dividend” payers, and buy those for your portfolio as tax-smart stand-ins for high dividend payers.”

When you buy an investment house, there are two things you can do with it:
You can rent it out, getting a small portion of what you paid over a long time (like dividends)
or
you can hope to sell it for more than you paid (like capital gains)

If you hope to flip it quick, then you don’t care how much it might get in rent.

So, for example, if you were day trading, or if you were 99% confident that a particular stock was going to raise in value in a given time period, you might not care if it paid dividends.

The cat is certainly out of the bag on dividend stocks, but we’re nowhere near bubble range, IMHO. Just to pick one example, Coca Cola’s price to earnings ratio is a little less than 13 right now, which is perhaps not dirt cheap, but is reasonable. In the ’90s it was over 50. Now THAT’s a bubble-like valuation.

Of course PE ratio is not the only metric to look at, but it’s a good place to start.

Rjack, if you are a gambling man, I’d bet that dividend stocks will underperform in the next decade or so, as they revert to the mean (given they’ve outperformed so much in recent years).

Generally, value stocks slightly outperform growth stocks in the long run (according to studies). Note though that just because a stock doesn’t pay an explicit dividend doesn’t mean it isn’t a value stock. If you want to slightly overweight value stocks, don’t exclude from your stock screen parameters stocks that are value stocks that distribute earnings through stock buybacks rather than dividends (since this is the smarter tax way to do it).

Probably best though to just diversify and not bet one way or the other. Keep your high yielders in tax deferred accounts and your low yielders (silent dividend value stocks, growth stocks) in taxable accounts – and call it good.

How about index investing itself? For the past decade the S&P 500 index has returned precisely zero in nominal terms. Factor in inflation and… ouch. Yet it’s touted as a magic bullet more often than anything else. It may work well over the (very) long term, but if the past 10 years just happen to have been the final 10 leading up to your planned retirement, you’ve paid a heavy price.

Blindly following ANY investment method without thinking and tracking what you’re doing is dangerous, index investing included. The past 10 years have certainly proven that.

It’s the magic bullet because it has the best chance to beat inflation by the widest margin, and to provide you money in retirement for the longest possible. The whole point of indexing is so you can blindly follow it. 90% of the investing public has no time, patience, or the necessary fortitude to spend more than a few minutes a year on their investment considerations – so we have to recommend a blind answer, and that has got to be a large percentage of your portfolio in widely diversified indexes.

You are right. The past decade has been tough for stocks and indexes are no exception. Nobody should suggest that the ride will be smooth.

With the benefit of hindsight, we can all now pick out stock strategies that outperformed my VTSAX. For my part, I’d have bought leveraged houses until 2006, sold them and moved into gold. I would have promptly unloaded the gold at $1900+ this past Fall.

But having a crystal ball, I just kept added to my index position. Like you point out in your post, this means I got to buy a lot of shares over the decade “on sale,” and that has provided a far greater return than zero.

Thanks for some more dividend info! I’m not an expert, but DividendGrowthInvestor recommends The Dividend Champions list over the Aristocrats. Just wanted to share this so people have some other options or opinions. I haven’t done enough of this to know who’s “right” (if there is a right), I just wanted to share.

One thing I would caution with picking individual dividend stocks is understanding the fundamentals, and what they mean per industry.

It’s easy to get excited about a stock that pays 7% and has raised it’s dividend for 30 years. But if you aren’t educated enough to look at the “payout ratio” then you might not notice that they are paying out more than profits – sacrificing their future just to stay in the aristocrat list. Obviously this can’t be maintained indefinitely.

On the other hand, for some industry’s a payout ratio of 75% might be perfectly healthy, while in other’s in a huge red flag.

I know I made this mistake when I first started investing many years ago, so just thought I’d share my mistake… :)

Brave New Life, I’d contend that you have no reason to investigate a given stock at all. The market price of the stock pretty closely resembles what that stock is worth right now – no more, no less – and extra research isn’t going to give you more insight into whether the stock is fairly priced or not.

Only reason to buy an individual stock is because you want to build a well diversified, tax-smart, close-to-zero-expense-ratio portfolio, and to use the volatility in individual stock prices to practice market-neutral tax loss harvesting. On that basis, when adding to your stock portfolio, you just look at your overall asset allocation and asset location (are all your high yielders in tax-deferred accounts?) to decide what kind of stock you need next to put you closer to your target, and then use a stock screen tool to find a stock that fits (i.e. what sector, what yield, what market cap, what debt-to-equity ratio if you’re using junk bonds in a tax-deferred account to offset indebted individual stocks held, etc).

Beyond that, knowing its payout ratio doesn’t help you much if at all. If it’s too high or unsustainable, rest assured, the market almost certainly already discounted the stock price to reflect that undesirable factor.

That’s assuming a truly efficient market. While I believe there is efficiency, I’m pretty confident that understanding the industry and the fundamentals allow for some opportunity to take advantage of some inefficiency.

But your point is well taken that much of the risk is offset by market efficiency. On the other hand if you are going to bank on that, I’d avoid individual stocks altogether and go the index route.

Interesting – you think you have some insight that allows you to do what extremely few individuals been able to consistently do (namely, beat the market). Good luck to you. I’ve not seen any study that shows anyone can beat the market consistently through fundamental or any other kind of analysis.

Even if you believe 100% in market efficiency, an investor can still buy individual stocks to take advantage of their individually greater volatility to make market-neutral tax-loss harvesting easier and more fruitful. Just be sure to hold 50+ stocks, selected only for their diversification attributes.

I try to keep track of these in a portfolio I set up on Marketwatch (its a free service). There are over 100 of them if you include the lower-yielding ones. Between these and the Dow components, these are about the only equities I would consider buying.

However, they are not too beaten-up right now, so I’m staying out for the moment.

That is something you have to consider — the possibility of bankruptcy. So its usually better to focus on larger companies. Ones going bankrupt are usually down 75% or more, though, like you saw in 2008 — now that is an extremely rare event!

If you just look at the Dow (as an oversimplification), you will find every couple years that one or more of them have declined by 50%, including MSFT’s famous fall in 2000 (followed by a 52% rise the next year). As another example, MO was down over 50% in 1999 and up 91% the next year.

On that plane, this year I might consider BAC or AA, although I don’t trust BAC’s books and its performance has more to do with Federal Reserve actions than anything else. I’m staying away until around March and will look at it again.

Another selection I like to look at is the highest price Dow component that had a losing year the previous year. Last year that would have picked you JNJ. This year its CAT. But I’m just very leery of everything right now. Last year was not “bad” enough overall.

And yes, I do park in cash (usually FXY actually for my “stock market” money) for long periods of time. And invest in other things like bonds and gold for diversification, but that’s off this topic.

All Righty, Dan! .. I appreciate the active participation, but keep in mind that you have already made 57 comments on this topic in the previous dividend article, and you’re moving along the same road for this article. I’d say you have thoroughly made your point now.

I don’t want to spoil your fun, but these comment sections don’t work well as ongoing discussion forums – they get too long, which makes them less fun for other people to read in the future and discourages new people from contributing.

For more in-depth chats, you can always start something on Reddit or your own blog, and I’d like to add a forum here as soon as I can find a reasonable one. Many thanks for your consideration!

No worries. Understood, MMM. Will try to limit the usage of the response functionality, and avoid (as much as I can stand it!) using it as a forum / ongoing discussion / Q&A. You can learn a lot from people’s responses and further thoughts though!

Maybe you should start a forum on here MMM. Just link to it on the top bar there. There is way too much to talk about on this site to keep quiet like that. Lots of exciting topics make a person want to vent. Just start subdomain like forums.mrmoneymustache.com. Maybe you can appoint some moderators to organize the topics or something.

Great Article! I’m new to this world of thinking how to make money other than by earning a paycheck and it all made sense to me. I hope between this blog and Sean’s Renewable Wealth, I can learn how to do something different to earn money that I can also feel good about and understand.

Just wanted to put my two cents in here…dont think we are anywhere near a dividend bubble..but I think common sense is luring common investors to dividend stocks. Where else is a retiree supposed to put his money to earn an income? The Bank? LOL. Treasuries? CDs? The Fed is killing the savers in this country, so they have nowhere else to turn. When the rates go back up, you will see some retirees moving their funds out of dividend stocks. But who knows when that will happen.

I’ve owned DVY ( a dividend focused ETF ) for a number of years. In its first year, 2003, it traded in the mid 50s and paid a quarterly dividend of $.46/share or nearly 3.5%. Now it trades in the low 50s and pays a quarterly dividend of $.44/share. This is in a rollover IRA of mine and I just reinvest the dividends. It’s a pretty boring investment. In 2011 it was up about 11% including dividends, so the price has run up a bit but it doesn’t seem like a bubble to me. Over the last 8 years the total return has been pretty meager but I’ve stuck with it because it seems to complement the mostly low dividend holdings in my 401k and taxable mutual fund accounts. The quarterly dividend peaked at $.68/share in 2008 and I suspect that it will eventually climb back up to that mark. During the recession this stock fell from a high of 73 to a low of 34, so much more volatility than conventional wisdom would seem to expect out of a divident fund. That’s been my experience, sadly no magic beans here.

Great blog, MMM. I would highly recommend to your readers the Bogleheads guide to investment book and the Bogleheads forum. The information in that book and the regular contributors on the forum should help temper the potentially dangerous notion that one can just read a few books, do some internet research in one’s spare time, and pick market-beating stocks that the thousands of professional stock-pickers and other hobbyists have somehow missed. I’m not trying to start another debate, just offering a different perspective and what I think is a useful resource for DIY investors. (By the way, Dan, thanks for fighting the good fight.)

I liked the fact that it focused on high dividends, without being overly concerned with market capitalization, which ends up being too heavy in companies I just can’t stomach putting large portions of my money in (ethically).
Not that the lesser known companies of SDY might not be just as bad, given the chance, but the list of the largest market capitalization companies just reads like a front for the League of Evil

If someone is planning on retiring when they are 65, it’s pretty obvious that you would put your saved monies in a tax advantaged retirement account of some sort.

My question is, where do you put your money when you consider retiring early and withdrawing money before you are 65 or even 45 so as not to incur penalties from your Uncle Sambo? I supposed tax advantaged is out the window? The Roth IRA still works, but where to, after you hit the yearly cap on Roth contributions?

I’m just got out of school. I own a small business on the side on top of a six figure salary so I can work the system a little with my own independent retirement account. My question is, what accounts will allow for withdrawal before age 60 without penalties? Will I still be able to play with before-tax dollars or will I only be looking at after-tax investments? And if I’m locked into a retirement account with pre-tax money, don’t the dividends have to go back into the account? Is there a way around that?

Same! So excited about making progress! Already made several changes and planning more. For now, I’m learning about investing, but my focus is my student loans, so paying those off gives me time to digest everything I’m reading.

I’ve been investing in stocks for close to 7 years now, ever since I started earning my paltry $300 a week in 2007. I made mistakes and had some successes. Bought two cars with the money from my investments and currently looking towards an early retirement soon.
I started using Warren Buffet’s techniques (more precisely Benjamin Graham’s techniques) some three years ago and saw a dramatic rise in my stock earnings. I had always picked my own stocks and learnt a lot in the process. Plus I do love the idea of being able to decide if a stock is a good buy, no matter the direction the price on the market is headed

I’ve been an avid reader of the blog for a while now and absolutely LOVE your mentality towards life, retirement, etc.

However, I’ve gotten myself pretty confused over how to invest. My wife and I own our home, plus have a rental property at a 2.75% (15 year) mortgage rate. We currently are living very frugally and investing considerably through betterment in a diversified portfolio that Betterment set up. I don’t want to retire anytime soon (I’m a pastor and really enjoy my job), but I’d like for my wife to be able to stop working in a few years.

Now to my confusion…I’ve read a BUNCH of your articles and can’t seem to understand how exactly you recommend to invest. In some articles it seems like you recommend just putting the money into 3-4 Vanguard Index Funds, in other articles (like this one) it seems like the recommendation if to invest in dividend-producing stocks, and in other articles you recommend investing through betterment.

Jesus, I swear, reading brought a comment thread like this one makes this investing baby’s head spin. As someone super late to the game my immediate focus is continuing to reduce spending and erasing CC debt.
But, damn, I need the investing part to be a little easier to understand. All the acronyms and industry jargon is tough to wade through. Thanks MMM for moderating some of that.
OK, back to reading.

I’ve been reading that qualified dividends are tax-free if you are in a 15% bracket (or below). Do these ETF (or indexes) keep track of that? Do they tell you at the end of the year: these dividends are qualified and these others are not? Better yet: are there indexes or ETF or whatever that invest only in qualified-dividend companies? This would be nice so in retirement and being in a low bracket I could “spend” my deduction, exemption and lower bracket in Roth conversions.

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